Updated 03 December 2020
We’ve grown used to thinking of Conservative governments as being all about tax cuts. But a leading economic think tank has warned that tax rises are now necessary to deliver on spending plans. We offer some predictions based on the options available to the new Chancellor. Article by Nick Green.
Pressure is mounting on the newly appointed Chancellor, Rishi Sunak, to increase taxes in his November Budget. A report by the Institute of Fiscal Studies (IFS) has claimed that the government’s existing spending plans and economic targets will not be possible without turning once again to taxpayers.
The Conservatives’ election manifesto committed to a number of fiscal targets, including strict rules on borrowing, but also pledged not to raise income tax, National Insurance or VAT. Having also made bold spending commitments, the government now faces a black hole in its finances that needs some urgent filling in.
Of course income tax, NI and VAT are not the only taxes out there. Several other potential sources of tax revenue suggest themselves, so it’s likely that the upcoming Budget will involve a raid on at least one of those. The first 2020 Budget in March saw most areas escape, but they may not be so lucky this time in the wake of coronavirus and lockdown. Here are the possible targets in the Chancellor’s sights.
Pensions represent some of the most generous tax protection available to savers – so are a perennial temptation for any Chancellor. A swift reconnaissance reveals several different areas from which additional tax might come.
Currently, when you access your pension pot (which you can do from 55 onwards) you can take 25 per cent of the money tax free. All other pension income is subject to income tax in the same way as a salary (though you no longer have to pay NI contributions after you reach state pension age).
The IFS has suggested that the 25 per cent figure could be reduced, exposing more pension income to tax. With the average pension pot sitting at (a very inadequate) £62,000 and around 600,000 Brits retiring each year, reducing the tax-free lump sum to 20 per cent could free up over £1.8 billion of extra revenue. The move would of course be unpopular, but those who had already retired and taken their lump sums would not be affected.
If you have a workplace pension, you can pay into it yourself (employee contributions) and your employer can also pay in (employer contributions). You can claim back income tax on employee contributions, but not the NI you’ve paid (usually at 12 per cent). For this reason, having your employer pay directly into your pension can be more tax-efficient, as it involves neither income tax nor NI for the employee.
Consequently, many employers offer ‘salary sacrifice’ schemes that allow employees to reduce their salary in exchange for a larger employer pension contribution. The government could recover a lot of tax by levying NI contributions on these payments – or simply by scrapping salary sacrifice schemes altogether (of which more in a moment).
For years there have been calls for the government to abolish higher rate tax relief. This would put all taxpayers on a level playing field, able to reclaim 20 per cent of income tax on their pension contributions, but no more. On the plus side, this would net more than £11 billion extra in tax; on the other hand, it would increase tax bills for people earning £50,000 or over and go against the Conservatives’ election promises. It will be interesting to see which way this one goes.
Coincidentally, another side effect of removing higher rate tax relief would be the likely end of salary sacrifice schemes. Such schemes could be used as a loophole to get around such a tax rise, so would have to be closed. Reading between the lines, it seems that salary sacrifice schemes may be one of the most likely casualties of the upcoming Budget.
Pensions are currently one of the best vehicles for passing on wealth to the next generation, since pension pots can be inherited free of tax. But the IFS has blasted this arrangement as ‘ludicrously generous’ and has recommended focusing on this rather than higher rate tax relief.
Currently, inheritance tax (IHT) is payable on everything in a person’s estate above a £325,000 tax-free threshold (although special rules currently apply for main residences – more on that later). If the government were to change the rules so that pension pots fell inside a person’s estate, then up to 40 per cent of inherited pension pots could be taken in tax. This would remove one of the great advantages of pension saving, of course, so would be very unpopular with older voters in particular.
It is also conceivable that a separate kind of tax might be levied on inherited pensions, starting at a lower rate. This might be seen as more palatable than leaping straight from zero tax to 40 per cent.
Looking beyond the world of pensions, we turn to those other possible sources of revenue beyond income tax, NI and VAT. One of these is the ‘Residence Nil Rate Band’ (RNRB). This was introduced in 2017 to enable homeowners to pass on their main home to their children largely (or completely) free of inheritance tax. But Rishi Sunak has faced calls to reform this system, with accusations that it is complex and can be unfair. Simply raising the ordinary nil-rate band of IHT (perhaps to a slightly lower level than the RNRB) might help solve both problems.
Other potentially viable tax increases could affect businesses:
Entrepreneurs’ relief lets you sell your business (or shares in it) and pay only 10 per cent capitals gains tax (CGT) on the profits you’ve made, up to £10m in total. Higher-rate taxpayers would normally pay 20 per cent CGT, so this can be a significant saving. Entrepreneurs can save up to £1m in tax over their lifetime.
The Conservatives promised not to raise income tax, but said nothing about corporation tax. This makes it at least a theoretical target for the Chancellor. As for tax on dividends, this technically counts as income tax even though it is lower than regular income tax – but Sunak might just use this discrepancy to justify a rise.
Reforms to the off-payroll working rules for contractors (known as IR35) are already lined up and due to come into effect from April. They will affect nearly a quarter of a million contractors and tens of thousands of companies, and could significantly increase the tax take from both as companies may be forced to treat some freelancers as employees and put them on the payroll.
The Chancellor has promised that HMRC will not be ‘heavy handed’ in the first year of IR35; an ominous statement which suggests that they will become so from April 2021.
There are several further possible sources of tax revenue for the Chancellor to pick over. One of these is fuel duty, which has been frozen now for a decade. Fuel duty has a notorious history, being responsible for major protests under the last Labour government. However, the current government may now feel safe enough to end the freeze, to net around £4 billion extra per year.
The IFS has also suggested that increasing council tax bills on more expensive properties would make the system fairer, and this extra revenue could be diverted to central government funding.
It is clear that Rishi Sunak faces some dilemmas in his second Budget. Whatever he chooses to do is bound to upset a lot of people, among supporters and opponents alike. If he doesn’t raise taxes, his government becomes unable to deliver their manifesto pledges; if he does, he risks alienating either core supporters or new ones.
Clearly, not all of the possible tax rises listed here will happen. But it would be a surprise if at least one of them does not feature in the Autumn Budget.